What is a Waterfall and Promote Structure in Commercial Real Estate?
A waterfall and promote structure, also known as a waterfall model, is a method for distributing the profits from a real estate investment in an uneven way. Typically, the project's sponsor (the individual or group putting most of the work in to identify, acquire, and manage the property) will receive a disproportionate share of the profits, known as a promote, as long as the project hits certain profitability benchmarks.
How Waterfall Structures Work in Practice
In most cases, if a waterfall structure is used in a commercial real estate investment, the exact nature of the structure will be laid out in the owner's agreement. The entire structure is usually based on something called a 'return hurdle,' a specific amount of profit that the project needs to generate in order to progress to the next hurdle. Usually, this is defined by a project's internal rate of return (IRR). So, for example, if a sponsor invested 5% equity in a project in a $1 million project ($50,000), and an investor invested 95% ($950,000), the first hurdle could be a 9% IRR. For any returns below 9%, the sponsor will get 5% of the profits, and the investor will get 95%. However, for any returns above 9%, the sponsor will get 10% of the profits, and the investor will only take 90%.
If, for example, the project generated a 12% IRR in the first year, that would equal $120,000 in profit (assuming no taxes.) The sponsor would get 5% of the first 9% ($90,000), which would equal $4500, and then would take 10% of the profits above 9% ($30,000), which would equal $3000. So, in this case, the sponsor would get $7500, getting a 15% return on their investment, while the investor would get $112,500, getting an 11.8% return on their investment. Many waterfall structures have multiple hurdles-- for instance, in the example above, there could also be return hurdles at 13% and 16% IRR, each which would provide the sponsor a greater proportional return, say, 15% and 20%, on the profits over those amounts.
Preferred Return in Waterfall Structures
In many equity waterfall structures, there is also something called a preferred return, which allows certain, preferred investors a first claim on any profits until they achieve a specific rate of return. In the example above, if the preferred return for the investor was set at 8%, and the property only generated a 7% IRR, the investor would get as much of the profit as it took to reach that 8% hurdle, even if it left the other investor (in this case, the sponsor, with nothing, which it would, if we were to calculate it out.) If this distribution happens upfront, it's called a catchup provision. In other cases, this is structured as something called a lookback provision, which stipulates that, if, by the end of the deal, the preferred investor has not met their preferred return hurdle, the sponsor has to give back any profits they have until the investor reaches it.